Question

5. Refer to Exhibit 1 below. What is the best estimate for the firm’s after-tax cost of debt?

6. Refer to Exhibit 1 below. What is the best estimate for the weight of debt to use in calculating the WACC?

Exhibit 1

A firm’s abbreviated balance sheet along with additional information are provided below.

Assets Current Assets $ 38,000,000 Net Plant, Property, and Equipment 101,000,000 Total Assets $139,000,000 Liabilities and Equity Current Liabilities $ 19,000,000 Long-term Debt (40,000 bonds, $1,000 par value) 40,000,000 Total Liabilities $ 59,000,000 Common Stock (10,000,000 shares) 30,000,000 Retained Earnings 50,000,000 Total Shareholders’ Equity 80,000,000 Total Liabilities and Shareholders’ Equity $139,000,000 The stock is currently selling for $19.95 per share, and its non-callable $1,000 par value, 20-years until maturity, 8% coupon bonds with semi-annual payments are selling for $880. The stock’s beta is 2 and the risk-free rate is 3%. The expected return on the market is 10%. The firm’s marginal tax rate is 25%.

Answer 1

Before tax cost of debt can be found using RATE function in EXCEL

=RATE(nper,pmt,pv,fv,guess)

Payments are paid seminally for the non callable bond

nper=number of periods=20*2=40

pmt=coupon payment semi-annually=(8%*1000)/2=$80/2=$40

pv=880

fv=face value=1000

=RATE(40,40,-880,1000,0)

RATE=4.67%

Semi-annual yield=4.67%

annual yield=4.67%*2=9.34%

Before tax cost of debt=9.34%

1. After tax cost of debt=Before tax cost of debt*(1-tax rate)=9.34%*(1-25%)=7.0%

2. WACC=(Weight of equity*cost of equity)+(weight of debt*after tax cost of debt)

Cost of equity=risk free rate+(beta*(market expected return-risk free rate))=3%+(2*(10%-3%))=17%

Market value of equity=Shares outstanding*share price=10,000,000*$19.95=$199500000

Market value of debt=40000*current bond price=40,000*880=$35200000

Weight of equity=Market value of equity(Market value of equity+market value of debt)=$199500000/(234700000)=85%

Weight of debt=$35200000/$234700000=15%

WACC=(85%*17%)+(15%*7%)=15.50%